Intermittent Purchases and Welfare-Based Price Deflators for Durable Goods (PDF)

The consensus among inflation watchers is that biases in official price indexes like the consumer price index overstate true inflation. We identify a new source of bias that works in the other direction. In particular, we use a simple dynamic model for durable goods—one type of good typically purchased intermittently—to derive equivalent variations and a true COL index. We show that, all else held equal, price indexes that rely on market prices will tend to understate the true COL index. With intermittent purchases, the true COL index is based on reservation prices and those prices lie below the market price in periods when consumers opted not to make a purchase. Hence, an equivalent variation that compensates consumers for observed changes in prices will be too generous, thus causing a downward bias in price indexes that rely on market prices.

Ana M. Aizcorbe and Adam Copeland